The Road Not Taken (in recent years)

Good Evening: While I was away, the markets celebrated our government’s latest plan for ending the financial crisis. Today the stock market retreated either from exhaustion, Treasury Secretary Geithner’s warning about our nation’s banks, the Obama administration’s ouster of GM’s Rick Wagoner, or a combination of all of the above. So clear to investors only last week, the road ahead now looks like it could lead us either higher or lower. Perhaps our policy choices and how we implement them will make all the difference. I’m going to breeze through today’s market action in order to devote more space to this theme.

Markets around the world were already under pressure as the Geithner and Wagoner stories hit the tape early this morning. Stocks in the U.S. opened 3% lower across the board this morning before settling into a fairly gentle trading range. At the day’s lows, the major indexes were off between 4% and 5%, and only a minor rally in the final hour of trading prevented stocks from closing with hefty losses. Not that the NASDAQ’s closing loss of nearly 3% was much to brag about, but it certainly was better than the 4.5% decline in the Dow Transportation average. Treasurys finally caught a bid, and it wasn’t the Fed’s bid for longer dated securities that did it, either. Shorter maturities saw their yields drop by 8 bps, while 10 and 30 year yields were off by only 2 to 4 bps. The dollar also found buyers, but commodities suffered along with stocks. With crude oil and its products leading the way lower, the CRB index finished down 3.5% today.

In thinking about our markets while I was away last week, the hopes for Tim Geithner’s latest plan and the stock market rally it spawned left me wondering whether our economy and markets are now at a crossroads. At once perplexed and inspired, I pulled up Robert Frost’s famous poem, “The Road Not Taken”. Here is the fourth and final stanza:

I shall be telling this with a sigh
Somewhere ages and ages hence:
Two roads diverged in a wood, and I—
I took the one less traveled by,
And that has made all the difference.

If Mr. Market could be likened to Mr. Frost’s traveler, then what path forward will the old gentleman soon choose? Will this latest in a multitude of policy responses from the Treasury Department and Federal Reserve lead him on a self-sustaining upward journey, or will these governmental actions do little to interrupt his previous descent?

These questions are tackled from different angles in both the latest “Market Focus” from Credit Suisse and an article in today’s Wall Street Journal (see below). The CS team scours through scores of historical charts in pointing out that stocks will decisively either rally or fall from these levels; a period of sideways trading looks most unlikely in their view. The Credit Suisse researchers make a number of assumptions in their analysis, not the least of which is that the March low in stock prices represents THE bottom. From decisive lows, muses Credit Suisse, what do the next 100 days of trading look like? Out come the charts, and comparisons with 2009 are then made with most of the bottoms seen during the last 80 years. Credit Suisse leans toward a positive resolution for both equities and the global economy, but in either case, CS sees the next couple of months as crucial. The key factor, according to Credit Suisse, is that massive government intervention will enable the world to avert a depression.

Just how a modern depression might look is the subject of an article by the same title on page 2 of today’s Wall Street Journal. Author Justin Lahart trots out charts of his own to compare today’s economic statistics (best described as, according to Jim Grant, “The Great Recession”) with the brutal and seasonally unadjusted numbers produced during the Great Depression. According to the data, the U.S. has yet to match the misery of the early 1980’s, let alone approach the devastation visited upon it during the early 1930’s. I have no quibble with these facts as presented, nor do I disagree with the forecasts among economists cited in the article that a 1930’s style depression is a long shot (a 15% chance is the mean estimate). The key passage for me, however, is the following one:

“Today’s government response is a far cry from the early 1930s, when the Fed raised interest rates, the infamous Smoot-Hawley Tariff Act crushed trade and Treasury Secretary Andrew Mellon’s prescription for the economy was “liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate.
“‘The Great Depression was a mass of policy errors that made it worse,’ says historian and investment consultant Peter Bernstein, 90. ‘This time we have our fill of policy errors, but at least they’re not making it worse.'”

To “they’re not making it worse”, I would add a simple “yet”. As much as I respect Peter Bernstein and his firsthand experience with the policy errors made during the 1930’s, I part with him on the subject of today’s policy errors. In my view, our government could easily be making things worse down the road. Whether headed by a Republican or a Democrat, our government during the past year has embarked upon a path of trying to borrow its way out of a crisis born of taking on too much debt. And, ensuring that we stay upon this road less traveled, Fed Chairman Bernanke has essentially promised to print whatever amount of money it takes to avoid the deflationary mistakes made approximately 80 years ago.

Eschewing liquidation, Mr. Bernanke seems to be choosing inflation, or at least a dollar-induced funding crisis at some future point. He doesn’t want to make the mistakes made in the past; he wants to make ones of the modern variety. If you doubt that investors will some day refuse to show up at Treasury auctions, I would refer you to last week’s failed auction of British Gilts as a harbinger of things to come should global investors come to doubt the wisdom of debt issuance cum monetization. The Fed can manipulate either the quantity of money (bank reserves) or its price (interest rates) — but not both. Mr. Bernanke is now trying to control both. I’m no economist, but this approach will only work if our creditors willingly suspend their disbelief. At some point the dollar might just cry “Uncle”, or long term interest rates might inconveniently rise to the point of choking off whatever monetarily induced economic recovery has taken root. If the “dollar standard” is ever abandoned, then both could happen at once.

Then what? What is the policy prescription for a world in which THE reserve currency is no longer trusted? Let me say that this suboptimal scenario is not a prediction; it is only one possible outcome from our government’s choice of the policy road “less traveled by”. We should also remember that, against a very different global economic backdrop, Japan did indeed choose a similar path to the one we now seem to be taking. Given that land of the rising sun has seen many false dawns in almost two lost decades, the road of borrow-to-stimulate-then-monetize has indeed “made all the difference”.

To avoid a depression, one that is either Great or long-lived, then the U.S. will have to be a bit more responsible (read: shared pain among stockholders and bondholders, management and labor — kind of like GM). Being the steward of the currency system known as the “dollar standard” demands that the U.S. encourages increased saving and a concurrent decline in borrowing and spending. The role played by China (and other Asian nations) should be an opposing one: Gradually reduce the hoarding of dollar assets, encourage domestic consumption, and let its currency rise over time. Rather than fixate over whether the road ahead will lead to either rising or falling asset prices, perhaps the best road to take would be the high one. It has certainly been less traveled in recent years.

— Jack McHugh

U.S. Markets Wrap: Stocks Drop Most in Three Weeks, Bonds Gain

Obama Says GM, Chrysler Have Last Chance to Survive

Geithner Says Some Banks Need ‘Large Amounts’ of Assistance

How a Modern Depression Might Look — If the U.S. Gets There


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